Anything lower than that is going to indicate that a project’s present value is going to be far less than the initial investment. So, as the profitability index value increases, so will the financial benefits of the potential project. Firms follow the profitability index rule to obtain ratios that depict returns with respect to each investment dollars.

How to Calculate Profitability Index

To best understand how to calculate and rank investment projects using the profitability index equation, consider the following examples. Anything lower than 1 indicates that the project’s present value is far less than the initial investment. So, the higher the profitability index, the more benefit and value you will get from it.

Example: IRR of a project

• Since project 2 and 3 both have higher PI values than project 1, they should be ranked ahead of project 1 while rationing the available capital.
• To calculate NPV all, we need to do is to add up all discounted cash flows and then deduct the initial investment required.
• This article will provide a detailed guide for calculating PI, how to use it, and the difference between profitability index vs. NPV and other valuation metrics.
• In the case of limited funds, we should rank projects according to profitability index (PI) ratios and not on the basis of their net present values (NPVs).
• The Profitability Index (PI) measures the ratio between the present value of future cash flows and the initial investment.
• Treat the profitability index as a helpful guideline, but always use it in tandem with the net present value method and other forms of multifaceted analysis.

The first thing you notice is that Project I has a larger scale compared to Project II — it requires larger initial investment and returns higher cash flows. The first project will return cash flows for a period of 10 years, while the second one is expected to deliver for 8 years only. We found out all of the above-discounted cash flows by using the same method. Only the cost of capital changed due to the increase in the number of years. Given the following cash flows for a capital project, compute the NPV and IRR of the project.

Profitability Index Formula Rules for Project Selection

Remember, numbers alone don’t tell the whole story; context and judgment complete the narrative. And lastly, investing in Catcher will earn Garch Ltd $155,000 in annual cash flow for the next 5 years. Should these be mutually exclusive investments, the second project will be preferable, even though it has a lower PI. This is how, if examined in isolation, PI ignores the size and added shareholder value of a given project.

How to Calculate the Profitability Index

Remember, a PI greater than 1 is not just a number—it’s a signal that an investment could lead to prosperity and success. Because profitability index calculations cannot be negative, they must be converted to positive figures. Calculations greater than 1.0 indicate the future anticipated discounted cash inflows are greater than the anticipated discounted cash outflows. Calculations less than 1.0 indicate the deficit of the outflows is greater than the discounted inflows, and the project should not be accepted. It may not always indicate the correct decision when ranking projects but would certainly provide an insight into the cost-benefit efficiency of one monetary unit invested. Despite its relevance, this index uses just an estimate of the cost of capital in its calculation, so it should not be reviewed on a stand-alone basis.

It is because there are instances where there re larger cash flows, but then the PI is limited due to the restricted profit margins. Hence, it is important to be wise when implementing this technique for accurate results. The NPV @ 14% in last column of the above table has been obtained by subtracting the initial investment at C0 date from the present value @ 14% discount rate. A profitability index greater than 1.0 is often considered a good investment, as the expected return is higher than the initial investment.

You can use a profitability index template or table like the one below to plug in your values. A PI template helps give a visual representation of the present value of future cash flows in order to calculate your project’s PI. It’s important to note that one problem what if i owe money to the irs with using the profitability index is that it does not allow a business owner to consider the full scope of the project. Using the net present value method of evaluating investment projects helps mitigate this problem, but raises other details worth considering.

But the company also needs to consider other projects where the PI may be more than 1.3. In that case, the company should invest in a project that has more PI than this particular project. Get new tipps on retirement savings, investment decisions and antifraud tipps. Using the PI formula, Company A should do Project A. Project A creates value – Every $1 invested in the project generates $.0684 in additional value.

From the above computation, we can come to the conclusion that ABC Company should invest in the project as PI is more than 1. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path. In order to help you advance your career, CFI has compiled many resources to assist you along the path. Download CFI’s Excel template to advance your finance knowledge and perform better financial analysis.

The initial costs include the cash flow required to get the team and project off the ground. The calculation of future cash flows does not include the initial investment amount. Profitability index (PI) is the ratio of present value of a project’s expected future cash flow and initial investment needed to undertake the project. It helps companies and investors measure the expected return for each dollar invested into a project or venture. Other names used for profitability index are the value investment ratio (VIR) and the profit investment ratio (PIR).